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The following note is work-in-progress.It is part of an attempt to bring to an end the great mass of confusions that have cluttered discussion of ‘quantitative easing’ in the UK’s monetary policy debate and indeed the monetary policy debates of many nations, in the last few years.Work on the note will resume next week…and perhaps in the following weeks.

A commonly-expressed view in the media is that Chancellor Osborne’s failure to curb the budget deficit is due to weak tax revenues, which in turn are to be explained by the economy’s weak supply-side performance. According to this analysis, the economy’s inability to generate more tax revenue is attributable to its more fundamental inability to increase output at all. Since supply-side remedies take a long time to work. Osborne is by implication not to blame for the persistence of budget deficits in the range of 5% - 10% of gross domestic product.In the note below I dispute this position. I show that in the last few quarters the Conservative-LibDem coalition government has let general government consumption rise faster than total national expenditure, which is dominated by the private sector. General government consumption is not to be seen as equivalent to total public expenditure, which also includes capital expenditure and transfer payments [i.e., welfare expenditure, pensions, debt interest]. Nevertheless, a government genuinely committed cutting the deficit would have made a better job at trimming public expenditure.

Mario Draghi denies that he is an actor. But in July last year he is reported to have paused, with great effect, between two sentences in an interview for the Financial Times. The two sentences were, ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough.’ On the basis of these two sentences, which were followed by a spectacular rebound in the euro on the foreign exchanges and in European share prices, the FT made Draghi its ‘Person of the Year’ for 2012.* But Mario Draghi, like King Canute, is not omnipotent. He cannot break the laws of arithmetic and the principles of accountancy which depend on those laws. He cannot – by mere pronouncement – conjure up the real resources required to fill the hole in Cypriot banks’ balance sheets. Equally, if that hole is €17b. (or about 80% of Cyprus’s GDP of €22b.), the Cyprus Parliament cannot by rejecting the terms of an international bail-out make the people of Cyprus richer in any meaningful sense. The cost of filling a hole of €17b. is the cost of filling a hole of €17b. It was supposed to be met by an increase in Cyprus’s public debt of over €10b. and the highly controversial deposit haircut of €5.8b. The Cyprus Parliament’s unanimous rejection of the haircut does not mean that – automatically, immediately, magically and finally – the €5.8b. has fallen like manna from heaven.We have a stand-off. The ECB has indicated that, on the provision of the appropriate collateral (Greek government bonds?), it will lend to the central bank of Cyprus sufficient amounts for it to meet cash calls from the commercial banks. These banks would then have enough cash to repay depositors with legal-tender notes. But do Cyprus’s banks have appropriate collateral in sufficient amounts? Do they, in Draghi’s terms, have ‘enough’?

I had hoped this week to finish my note on ‘Is UK monetary policy on the right lines?’. However, after writing 2,000 words (and putting together the data for four charts), I have run out of time. This note is therefore numbered 1 ½ rather than 2, and I will return to the exercise next week.The note below concentrates on the years running up to the crisis of 2007 and, more particularly, of 2008, years which passed by the reassuring label of ‘the Great Moderation’. In this period the growth of the quantity of money was consistent with nominal GDP growth of about 5% a year and 2% inflation. Money balances grew as banks expanded their loan assets and ‘bank lending to the private sector’ was the dominant so-called ‘credit counterpart’ to bank deposits. A consistent negative influence on money came from banks’ capital- building. This was necessary of course as banks added to the risk in their balance sheets, and incurred non-monetary liabilities in the form of equity and bond capital. From mid-2007 the pattern of money growth changed radically. From Q3 2008 officialdom placed intense pressure on banks to hold more capital relative to their balance-sheet risks, causing i. a contraction in ‘lending to the private sector’ (in fact, implemented mostly by sales of securities), and ii. a massive programme of capital-raising. These two shocks caused money growth, which has been too high in 2006 and early 2007, to collapse and even threaten to go negative. In early 2009 policy-makers, facing a macroeconomic catastrophe, had quickly to find a means of boosting the quantity of money. (The next instalment of this note – which should be the last – will discuss the role of ‘quantitative easing’ in the resulting macroeconomic salvage effort.)

Rising employment in Britain in recent quarters argues that a recovery is under way, even though it is disappointing by the standards of the past. Official data in recent quarters almost certainly understate the level and rate of growth of output. The understatement may arise because of the difficulty of calculating price indices in an economy dominated by service output, and characterised by extensive product innovation and improvement. (I have no idea how the national income accountants measure the output of Facebook. Twitter and Google.) At any rate, the persistence of employment growth suggests that macroeconomic conditions are normalizing after the trauma of the Great Recession. How should monetary policy now be organized? Do policy-makers need to ‘do more’ to stimulate the recovery? Or is monetary policy already on the right lines?The following note proposes that low and stable growth of the quantity of money remains the key to achieving macroeconomic stability with low inflation in line with the official target. It is suggested that the annual growth in the quantity of money, broadly-defined, should lie between 3% and 5% (or perhaps 2% and 6%) if policy-makers want to maintain consumer inflation of about 2% and moderate output growth at roughly the trend rate (which does not seem to be much above 1 ½% a year and may be lower). For the moment banks seem reluctant to expand their loan assets, despite the continuing verbal assault on them from Mervyn King, the media and others. But money growth at the desired low rate can easily be attained by varying the degree to which the budget deficit is financed from the banks rather than non-banks. Theological debates about ‘quantitative easing’ are unnecessary; they symptomize widespread misunderstanding about how monetary policy can and should be conducted. (This is the first half of a note which will be completed next week.)

The following note sets out the results of UK by-elections from the start of 2012, a period in which a (predictable) swing to the main opposition party, Labour, and an (unpredictable) swing to a less-than-20-year-old one-issue party, the UK Independence Party, have occurred.Averaging all the by-elections and excluding the March 2012 Bradford West by-election, the swings are of about 10% from both Conservatives and Liberal Democrats, and of about 10% to both Labour and UKIP.If the Bradford West result is included, the swing to Labour is reduced substantially, to about 5%. The explanation is the large swing to Respect, a breakaway political force under Mr. George Galloway

Disillusionment with politics – or at any rate with the current political elite – is rife in Britain at present. The UK Independence Party has made astonishing gains in the last three years. In the 2010 general election it received about 3% of the vote, but opinion polls and canvassing returns show that in the Eastleigh by-election (result due on Thursday, 28th February) it should achieve more than 15% of the vote and its share may even approach 25%.British politics is in flux. In the following remarks, which are based on an e- mail distributed to UKIP supporters* earlier today, I analyse prime minister Cameron’s disastrous strategy to ‘modernise’ and ‘rebrand’ the Conservative Party. The result of that strategy has been to alienate support from an important Conservative constituency, namely the Cs and Ds (the lower middle class and working class) who – when they do not vote Labour – are often particularly ‘right-wing’ in their political orientation. (The ‘patriotic working class’, etc.) The Cameron strategy has been responsible for upsetting many true conservatives who dislike/deplore the prime minister’s politically-correct agenda on social issues.My surmise are that

i. the Conservatives will lose heavily in the 2015 general election and then split, with the majority of the party moving in favour of withdrawal from the EU, and

ii. the polarisation in British politics in the next few years will be less on class lines and increasingly on the European issue

* I was runner-up in the 2010 UKIP leadership election and am therefore biased. I am of course not going to hide this.

The Greek government recorded a surplus on its finances in January, an apparently heartening development in the continuing Eurozone melodrama. The surplus was the result of huge cuts in expenditure combined with the seasonal pattern of tax payments, which has the effect of making January a month of unusually high tax receipts in every financial year. (Greece had a budget surplus in January 2010, also.) Key decisions on Greek public finances are now being taken by the troika, the group of international bodies (the International Monetary Fund, the European Commission and the European Central Bank) acting more or less in unison to ensure that financially distressed Eurozone countries can honour (some of) their international debts. Can these organizations at last start celebrating? Is austerity having the desired effects?In fact, the wider macroeconomic background in Greece remains appalling. The January outturn is unsustainable, and reflects both desperation and severe fiscal trauma. Needs must when the troika drives. Tax revenues were lower, by over 9%, in January 2013 than a year earlier. The surplus was ‘achieved’ only by a fall of over 20% in expenditure, from €5,362m. in January 2012 to €4,239m. last month. It should also be emphasized that in January 2011 expenditure was €8,408m. In other words, Greek government expenditure at the start of 2013 was half (yes!) the level of two years ago. The Greek state is having difficulty controlling its borders, with immigrants widely reported to be responsible for a crime wave. There is still a high risk that Greece and/or Cyprus will leave the Eurozone.

David Cameron has promised, or at any rate indicated, that a newly-elected Conservative government would in 2017 hold an In/Out referendum on EU membership. As the Conservatives are generally regarded as unlikely to win the general election in 2015, Cameron’s promise may not amount to much. Nevertheless, the debate on the UK’s relationship with the EU will be intense at least until the general election and probably for some years thereafter. The purpose of this week’s e-mail note is to describe key features of the international scene, particularly those relating to Europe’s role in the world, as background to the debate. The main point is simple, that the EU’s share in world output and population is falling sharply, and the importance of the EU to the UK’s international trade and finance will decline.The focus is on two dates, 2017 for obvious reasons and 2059. 2059 is chosen because it is 42 years from 2017, while 2017 is 42 years from 1975, the last time that the British public was consulted in a referendum on EU membership. By 2017 British politicians would have taken 42 years to refresh the original mandate for UK involvement in ‘the European construction’. The most neutral assumption is therefore that – if that mandate were renewed in 2017 – they would take another 42 years to seek to refresh it again. (This note expands the argument on an article in the February 2013 issue of Standpoint.)

What does companies’ monetary behaviour tell us?

QE is widely said to ‘have lost its effectiveness’. As I explained in my weekly e- mail note of 23rd November, QE is to be understoodas‘deliberate action by the state to increase the quantity of money’, while the claim that it is ineffective (or less effective) is equivalent to the claim that increases in the quantity of money have no effect (or a diminishing effect) on the equilibrium level of national income’. In my 23rd November note I reviewed the relationship between changes in the aggregate quantity of money (as measured by M4x) and changes in the UK’s national income over the last 15 years. A key fact emerged, that the increases in both the quantity of money and of national income had been lower in the last five years than for many decades. The vital word is ‘both’. Money and national income have moved together, bang in line with basic theory. On this basis claims of QE’s ineffectiveness are bunkum.This week’s exercise is somewhat different. All agents have a desired level of money holdings (relative to income and the attractiveness of money in comparison with non-money assets), and national income and wealth are at their equilibrium levels only when agents’ actual money holdings are equal to this desired level (i.e., in jargon, ‘when monetary equilibrium prevails’). But in the real world agents’ actual money holdings often differ from the desired levels, and transactions (indeed many rounds of transactions) are undertaken in order to move closer to equilibrium. The value of transactions in bank settlement systems – which nowadays is typically 50 times gross domestic product – includes transactions in capital assets. The main kinds of agent involved in these transactions include households, companies and financial institutions. The focus here is on the monetary behaviour of companies. I show that the ratio of money holdings to bank borrowings of British companies today is much the same today as it was 50 years ago, and that corporate monetary behaviour in the recent cycle has been much the same as in other cycles. To repeat, the notion of QE’s ineffectiveness is bunkum.